QE2 and Emerging Markets

America's latest round of quantitative easing---also known as QE2---set sail a few months back, and its departure (or arrival, depending on one's point of view) ushered in approbrium from much of the developing world's central bankers and ministers of finance. In their view, the move is an underhanded way of depreciating the U.S. dollar; indeed, this has already occurred, at least as far as the USD/EUR rate is concerned (see figure). The timing, of course, could not have been much worse: amid talk of global currency wars and a looming food crisis.

One important issue that has been somewhat neglected in the discourse thus far are the international financial dimensions of such a policy.

At one level, the analysis is fairly straightforward. Standard new open economy macro models suggest that unanticipated foreign monetary policy shocks---such as that implied by QE2---typically end up being welfare-positive for agents at home.[†] The standard policy concern of beggar-thy-neighbor competitive devalautions (resulting from monetary expansion) is thus alleviated, and developing countries can rest easy that, if anything, QE2 will be a minor boon for their economies.

Of course, the world is somewhat more complicated than even the most complex two-country open-economy models, and importantly, the implications of QE2 go beyond the (relatively) straightforward impact of monetary expansion on the level of exchange rates, terms of trade, optimal consumption-labor-leisure decisions. There are at least three important considerations that may affect developing countries in a nontrivial way: (1) implications of QE2 for countries with fixed rate regimes against the U.S. dollar; (2) what QE2 may mean for the future role of the dollar in the global economy; and (3) implications for future capital flows to emerging economies.

The most common criticism of the Fed is that QE2 is irresponsible monetary largesse, designed to prop up the U.S. economy while it makes an excruciatingly slow exit from recession. In some ways, this characterization may be a little unfair. After all, the Fed (as well as almost every other central bank in the world) has always been routinely involved in Treasury bond purchases and sales in the regular conduct of monetary policy, through open market operations; the main distinctions this time are mainly a matter of scale and maturity (and of course that pesky zero bound).[‡] Moreover, the expanded money supply in the United States has primarily appeared in the form of reserve holdings by Fed member banks, rather than actual currency in circulation. This is especially so since the Fed started paying interest on these reserves. The danger of galloping worldwide inflation due to a flood of liquidity, ipso facto, is probably overplayed.

That said, there are legitimate reasons---mostly to do with minimizing the real costs of exchange rate fluctuations, and exchange rate targeting being the lesser of two evils in the choice between inflation and exchange rate volatility---where an emerging market central bank may wish to run a fixed (or mostly fixed) exchange rate regime. Taking such a choice as given, QE2 may mean that these emerging market countries would be forced to fun a monetary policy that is far too loose, given the overall absence of spare capacity in their economies. The manifestation of inflation in many of the fast-growing emerging economies, then, is certainly no pure coincidence, and (to the developing country policymaker, at least) a necessary evil.

But is QE2 entirely innocuous for the U.S.? Certainly not. If you were asked to close your eyes and describe what a policy of "large-scale purchases of government debt by a central bank" would be, most would call such an activity (unsustainable) debt monetization. Indeed, this was pretty much the case in Latin America in the late 1970s---and, indeed, the description of such a policy was what inspired Paul Krugman to develop his pioneering first-generation currency crisis model.

Of course, owing the to "exorbitant privilege" that issuing the world's reserve currency confers, monetization need not result in a traditional currency crisis in the United States (since by definition it can always print the reserve currency necessary to finance its deficits). Still, a preponderance of dollars in the system would mean that the dollar becomes less valuable as a store of value: a major function of the dollar in its role as a reserve currency (and asset currency for the private sector). For emerging market central banks, a strategy of diversifying away from dollar holdings may well be a prudent one. Granted, the existingalternatives are not exactly attractive prospects, but with deepening financial markets and a seemingly greater willingness to expand convertibility, the renminbi appears poised to play a greater role as an international currency.

Looking further down the road, it is worthwhile to ask what QE2 may mean for the future of international capital flows. While interest rates on long bonds remain somewhat subdued, the 30-year has been on a steady rise since 2009, and it is not beyond the realm of possiblity that a combined double whammy of a disappointing fiscal outlook and continued loose monetary policy pushes U.S. interest rates significantly higher in a few years' time. Were this to occur, the United States would be competing even more directly with emerging markets for scarce global capital (which someoutfits have suggested will only exacerbate over time).

*. As an aside, it should be noted that the stated domestic objectives of the Fed---in particular, reigniting economic growth through exiting the liquidity trap---may well entail pursuing a policy of depreciation.

†. This is regardless of accounting for changes in labor-leisure tradeoffs, the exchange rate, terms of trade, and consumption. Indeed, one of the stark findings in the Obstfeld and Rogoff's Redux paper is that the positive welfare impact experienced at home is irrespective of the source of the monetary expansion, because the effects of expenditure switching and both consumption and leisure reallocation are in fact second-order in nature. Moreover, this result (at least for the non-stimulating economy) holds even when one allows for economic size and terms of trade effects.

‡. More precisely, the Fed's balance sheet is currently holding an unprecedented amount of nontraditional assets (such as mortgage-backed and agency securities), and a much longer-dated maturity distribution than usual.

Comments

Here is an issue to ponder. The U.S. current account deficit has been rising from the lows reached during the crisis. So even with QE2, net capital flows TO the U.S. - that finance the larger deficit - are larger now than before the crisis. Thus, QE2 does not directly contribute to capital outflows from the U.S.
Now, if QE2 had lowered long-term yields in the U.S., you could say that money is so cheap it is affecting global liquidity. But long-term yields have risen since QE2 started to be implemented.
Last but not least, well before the crisis began, the diagnosis of the U.S. dollar was that it needed substantial depreciation to help bring the U.S. current account closer to balance. And reserachers and even governments throughout the world were critical of the large U.S. consumption relative to GDP.
So what is the real issue?